Understanding 'The Futures'​ Market

• Today, we look at a market that's very popular with our trading teams.

The 'Futures' Market Explained:

Last Tuesday we talked about the Interest Rate futures market and what it is predicting for UK interest rates over the next few years. Since then, we have had a few emails asking for a little more information about exactly how futures work.

A futures market is an auction market in which participants buy and sell contracts for delivery on a specified future date. Futures are exchange-traded derivatives that lock in future delivery of a commodity or security at a price set today.

A ‘derivative’ is a financial product which derives its price from an underlying asset. This could be equities, bonds, wheat, oil or even orange juice (for those of you old enough to remember Trading Places). Pork Belly futures were sadly phased out in 2011.

Originally, such trading was carried out through ‘open outcry’ in trading pits like the one above, aided by the use of hand signals – but more info to come on trading pits next week.

Such pits were located in financial hubs such as New York (NYMEX), Chicago (CME) and London (LIFFE now ICE). Throughout the 21st century, like most other markets, futures exchanges have become electronic and are now traded via software on computer screens.

In order to understand fully what a futures market is, it’s important to first understand the basics of futures contracts, the assets traded in these markets.

Futures contracts were originally designed by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market.

Here’s an example of how futures are used:

In January a farmer knows that he will have 500 tons of wheat to sell next September, but he likes the price of wheat predicted for September right now. In the futures market he is able to lock in that price by selling the Sep wheat futures contract, thus agreeing to provide the wheat at the current price, but in September (called the September contract).

Whatever now happens between January and September is irrelevant for that farmer, as long as he produces the wheat. If the price of wheat goes up, the trader on the other side of the trade wins, if it goes down, the farmer wins.

Either way, the farmer is happy with the price. The seller of the underlying asset has taken the risk out of a fluctuating market by locking in a price he is happy with now and subsequently no longer has to be concerned about the price of wheat.

Wheat Futures contract price between June 2020 and March 2022 above.

Futures markets or futures exchanges are where these financial products are bought and sold for delivery at the agreed-upon date in the future with a price fixed at the time of the deal.

Futures markets have evolved a lot since the Chicago Board of Trade listed the first-ever standardised ‘exchange traded’ grain futures contract in 1864. Futures are now used for more than simply agricultural contracts, and involve the buying, selling and hedging of financial products and future values of hundreds of different assets.

Futures contracts can be made or "created" as long as there is an open interest. The size of the futures markets (which often increase when the stock market outlook is uncertain and markets more volatile) is larger than that of commodity markets and is now a key part of the financial system.

As markets become more sophisticated, we see traders use them more and more for speculation as much as for hedging purposes. If the farmer wants to sell the September wheat contract, someone else has to buy it.

If a wheat trader believes that the price will rise (as it has been doing), then they may well buy that contract even though they don’t actually want to receive any wheat. They are simply speculating that the price will rise, and they intend to sell the contract back into the market before it expires in September.

Taking delivery isn’t something a FTSE futures trader needs to worry about as when the FTSE contract expires, it is settled to cash. This means that the difference between purchase and settlement price is settled automatically between the accounts of the buyers and sellers ‘in cash’ (electronically).

Oil on the other hand, is not settled to cash. The buyer of a Crude Oil Future receives 1,000 barrels of oil after the expiration of the contract. One of the issues you might have heard about during lockdown was how the futures price of oil traded negative.

This is because countries and companies ran out of places to store the oil. As the world was locked down, it wasn’t needed. Once all the reserves and tankers were full, there literally was nowhere to put the oil if it was received so traders were paying to NOT receive any oil ie. the price was negative.

It was a short-term thing as space soon became available, although the price stayed low due to lack of demand.

It’s amazing to think that in the space of 2 (very different) years the price of an oil future can go from -$37 to +$125 a barrel. It is fluctuations like this that make trading derivatives so appealing to financial institutions.

At The Portfolio Platform, equity index futures are the most commonly traded product.

An equity futures contract works in the same way as a wheat contract. The parties involved must transact a buy or sell of a specific index at a predetermined future date and price. The price of the contract is namely determined by the spot price of the underlying index when the future expires.

Most futures expire quarterly. This means there are contracts available to buy or sell based on the price in March, June, September and December. The nearest month is the most liquid which is why most of our traders are currently trading the September contracts.

Equity Index futures allow us to speculate on the future price of a specific index, whether it is the FTSE, CAC, DAX, S&P500 or the Nasdaq etc. In the futures market, buyers and sellers have opposing beliefs about how the value of the underlying will realise.

A buyer of an equity futures contract will make a profit in the event that the value of the underlying has increased at the futures’ expiration and a loss if it decreased. On the other hand, a seller will make a profit when the value of the underlying decreases at the expiration and a loss if it has increased.

This works the same way for an equity index future, which is what our traders on The Portfolio Platform predominantly focus on. The buyer of a FTSE Future is speculating that the FTSE 100 will rise in value; the seller is speculating that the price will fall.

Wealth managers, IFA’s, investment manages and whomever else might be managing your money, will not trade index futures in the way we do. They aren’t traders. They might put 10% of the capital in ‘Alternative Investment’, meaning hedge funds etc. but they don’t trade themselves.

Futures trading takes many years of experience, and is all about trying to make as much money as possible. It’s speculative, and complicated, and best left to the professionals. Wealth managers don’t know much about derivatives and it’s a world apart from allocating assets to online funds.

Wealth managers divide your capital and allocate it to other people (various funds run by fund managers and algorithms), but they don’t actively trade your money in the same way as a trader would.

What used to take place in futures pits in London and Chicago, is now available to trade online, providing you are an experienced professional.

What The Portfolio Platform has done, is now make their professional traders available to the retail investment market. Technology has advanced and what wasn’t available to you before, is now available to you on TPP.

This:

Now looks like this:

Our software means our traders can do what they do, and your portfolio can be linked to theirs. Our front end system the allows you to log in a see what they’re up to with live updates. It’s so transparent, you can actually watch it as it happens.

Each strategy is between £50 and £75 a month regardless of how much you have in your portfolio. There is no 2% management fee. Our traders will trade, and that costs around £75 per month. That’s it. That is the only cost.

How do equity index futures work on margin?

In contrast to other products such as stocks, you do not pay the full cash amount upfront or own the underlying asset. You don’t own the FTSE as you might do a share. Instead, you have to deposit initial margin to enter into the index futures position.

The amount of margin required is a percentage of the contract value. This amount will vary a little from time to time depending on the volatility of the index but essentially the amount on margin is a deposit, to allow you to hold a position.

The deposit amount will always be significantly less than the total value of the underlying. Since only a percentage of the contract’s value needs to be put up initially, equity futures and equity index futures are leveraged instruments. This means that slight price movements can have a larger impact.

On The Portfolio Platform we have trackers for each index that run at roughly a 3:1 ratio. If you invest £25,000 into our FTSE tracker, then when the FTSE moves up 1%, your account will move 3%. This can be altered to 2:1, or any ratio of your choosing. If your wealth manager tells you the FTSE should make around 6% a year over the next 10 years, why not make 18%?

Futures contracts have a minimum price increment to which a particular contract can fluctuate, known as the tick size. This is determined in the specifications of the contract set by the exchange. Tick value, on the other hand, is the actual monetary amount that is gained or lost per contract per tick move and is equal to the tick size multiplied by the contract size.

For the FTSE 100, the tick size is 0.5 and the tick value is £5. This means that for every 0.5 point move up in the FTSE, the buyer makes £5, ie. from 7286-7287.5, the buyer has made £15.

This is simpler if you think of a 1 point move in the FTSE equalling £10. If you were to buy a FTSE future at 7286, and the price moved up to 7386 then you have made 100 points, or £1,000.

What hours do futures trade?

As a client of The Portfolio Platform, you will have noticed that trading doesn’t stop when the cash market closes. The cash market is exactly that, cash for stocks, whereas the derivatives markets do not require you to buy the physical asset so can be done at any hour electronically.

This means that futures markets don’t open and close at the same time. In fact, the stock exchange in London is open from 8am to 4.30pm whereas the FTSE futures market is open from 1am to 9pm.

If you hear on the morning radio that the FTSE will open 40 points higher at 7410, then that is because the FTSE futures market is already trading and is currently 40 points higher than the previous close.

It isn’t magic and the financial commentators aren’t guessing where it will open, the fact is, it’s already there.

The Portfolio Platform is a new dynamic platform built by traders for you, the investors. Link your own account to our traders and you could benefit from their expertise.

For more information, or if you have any questions about the article above, please do contact us here.

Summary

* A futures market is an exchange where futures contracts are traded by participants who are interested in buying or selling derivatives.

* Futures markets are regulated by each country’s regulator and futures contracts standardized by exchanges.

* Today, the majority of trading of futures markets occurs electronically, with examples including the CME in the US and the ICE in Europe.

* Unlike most stock markets, futures markets can trade 24 hours a day anywhere in the world.

* The Portfolio Platform allow you to link your own portfolio to our professional traders and do exactly what they do, when they do it.

* The account holder on TPP doesn’t need to actively manage their portfolio. The whole system is automated and autotraded.

If you'd like to schedule a call to discuss building a TPP inspired portfolio, you can do so by clicking here. Our trading teams are tasked with yielding 2-4 x market performance per annum. Whilst our portfolios are predominantly on the BUY side of the market, the variation of strategies hosted means you'll also gain some 'short sell' exposure, to take advantage of market falls, as well as being flat on occasion (as markets fall).

It's why TPP are different to your wealth manager or IFA, and it's why many are saying TPP is the future of investing.

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